Tianjin Plastics Case

VU University Amsterdam
Faculty of Economics and Business Administration

Course: Advanced Corporate Financial Management 4.1
Academic Year: 2014-2015
Date: 29-09-2014


Teacher: Prof. Dr. lr. H. A. Rijken
Group: 23




Student name / ID: Malika el Baktet 2056488
Student name / ID: Yasmina Adhar 2510294
Student name / ID: Emirlinda Metalia 2552526

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Contents

1. Introduction ..................................................................................................................................3
2. Risks .............................................................................................................................................4
2.1 Construction Risk ................................................................................................................................ 4
2.2 Operating Risk .................................................................................................................................... 4
2.3 Credit Risk .......................................................................................................................................... 4
2.4 Political Risk ...................................................................................................................................... 4
3. Project Financing ..........................................................................................................................5
3.1 Construction Financing ....................................................................................................................... 5
3.2 Post-Completion Financing ................................................................................................................ 6
3.3 Using Flow-to-equity method ............................................................................................................. 7
3.4 Risks Associated With Return ............................................................................................................. 7
4. Similarities & Differences with DBFMO projects ..............................................................................9
5. Conclusion .....................................................................................................................................9
Appendix ................................................................................................. Error! Bookmark not defined.


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1. Introduction
Maple is the developer of power plant, originating in US which has accomplished many
successful projects throughout different emerging economies in Latin America and also projects
in United Kingdom. Recently the company is operating in Asian markets and specifically in
India and China. The current project is related the construction of a power plant in this important
industrial city. Maple has created a joint venture with the Tianjin Plastic (an enterprise owned by
the government) and with MOPI (Ministry of Power Industry). Although the cooperation seemed
promising, the upcoming restrictions from the government side, would raise the uncertainty on
the feasibility of the project. Such restrictions as limiting the profit or currency convertibility
would have a great importance on the Maple financing decisions, as will be described below.
This case study is dedicated to the form of financing called project finance. It is a form of
financing which depends completely on the cash flows obtained throughout the operational phase
of the project and these future cash flows are also the collateral to lenders. The Special Purpose
Vehicle is usually the project company whose only business is the specific project. It is separated
in financial terms as well as risk indication properties, from its legal owners and investors. The
SPV has in its asset side the discounted cash-flows that are going to be attained throughout the
projects life. In the liabilities side there is a small amount of equity (in the specific sector this is
usually 15-30%) and the other part of financing which is with debt in the form of loans from
foreign and the Bank of China.
Due to the specifics of the project finance, it is a very crucial to match the cash flows with the
frequent payments towards the particular investors such as debt-equity holders. From one side
the lenders and debt-holders need to be assured that the cash flows will cover the interest
expenses and principal payments. In the other side the equity holders are seeking to attain their
returns in the expected rate and appropriate risk endurance. The project finance, in the most of
sectors, is characterized by a high level of leverage (with debt ratios of nearly 80%-90%). But
the predictability of the future cash flows, assured by long term contracts with the government
and the cost controlling in the long term agreements can mitigate the business risk and the
possibility of financial distress.


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2. Risks
There are different types of risks that are related to this project, namely: construction risk,
operating risk, credit risk, political risk and exchange rate risk.
2.1 Construction Risk
Construction risk is related to ability of the contractor to complete the project in the pre-agreed
conditions and is mostly addressed to engineering, technical features, construction contracts and
duration. In this case Maple has the highest responsibility towards this risk. This means that the
project will have an interest expense of 7.9 million dollar for every year. As a second risk is that
Maple is not able to complete the project with the budgeted costs, which leads to a situation
where Maple is forced to acquire new equity. Another construction risk can be a difference in
quality of the power plant and the required standard. The Maple Company has taken the
responsibility to face with this risk and to make sure that the above conditions are under control
and the quality of subcontractors must be of an acceptable position of technical expertise to
avoid cost overruns during the project.

2.2 Operating Risk
The project is unlikely to generate revenue until the operations period and so it is going to be key
to lenders and other investors that the revenue stream is certain and that forecasts of revenues are
accurate. Operating risk is the risk that exist in the way a company deals with the key factors
during the operating phase which are related to maintenance, efficiency, performance so that the
assets maintain their quality to sufficiently generate cash flows throughout the project. Lenders
and investors want to make sure that the assets remain productive throughout the life of the
project. So the lenders will seek for protection to the extent that affects the revenue stream. In
our case this risk may be low, because Maple has a reputational expertise in other countries and
has dealt with similar projects in the past.
2.3 Credit Risk
This is the risk that a borrower will fail to complete its debt obligations in time. This risk is
higher in the case of the borrower who expects to use future cash-flow to make his payment. For
this case the cash flows are guaranteed by the government in the contract, but as is indicated in
the case Chinese government often refused to fulfil project contract such as this, hence raising
the concerns of the lenders on the potential failure on meeting the debt payment obligations. The
debt on this project is arranged in tranches which are limited/non-recourse, thus in the case of o
probable failure, they will only seek the assets of the project (project companys contracts,
licenses, rights on natural resources) and not the assets of individual equity holders.
2.4 Political Risk
Political risk is the risk that the return of this investment can suffer because of political changes
or instability in China and deterioration on the contract terms due to change on the political
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environment. Firstly, the Chinese government revised the target ROI to between 15% and 17%
which was opposed by analysts who estimated it should be at 18%. Secondly the government
refused most of the time to guarantee fulfillment of a contract as this one. Lastly, the Chinese
government also did not give permission to repatriation of equity. So, although the joint venture
is arranged with local/governmental institutions, this doesnt mean that this risk will be mitigated
in some way. On the other hand the lenders may accept to undertake some risk, but this could not
be possible especially in an emerging economy, with ambiguous political environment at times.
So the political risk is probably more possible to be borne at some extent by the equity holders.
Exchange rate risk
This risk relates to currency fluctuations which is when the currency of the revenue and the
currency of debt diverge (i.e depreciation of Rmb) would cause a rise in the debt service
expenses which are at above 80% financed in foreign exchange such as USD. It cannot be very
clear to which party this risk should be addressed to bear. Key issue is the extent to which equity
may be expected to bear exchange rate risk. While equity sponsors are expected to take more risk
(and earn higher returns) than lenders, their preference is to bear risks they can control, such as
construction or operational risks, rather than exchange risks that they cannot mitigate. Investors
could best endeavor to bear the risk if there were sufficient hedging opportunities, which in fact
is lacking in the Chinese currency market. So it seems that government has to bear this specific
risk if it wishes to attract investors and also it can properly diversify it to taxpayers which are
large in number.
3. Project Financing
The financing of this project consist of construction financing of 4 years and the post-completion
financing. These phases will be explained shortly in the following paragraphs.
3.1 Construction Financing
The construction and testing takes 4 years and begins in 1996. In 2000 the operations of the
power plant as well the interest and principal repayments will start. Total construction financing
consist of a total capital of $117.4 million. This was provided through a combination of loans
from the project sponsors: equipment vendors, Tianjin Plastics, Maple Energy and bank loans.
The equity of $16.5 million is emerged from the joint venture, which can be split in Maple
(49%), Tianjin Plastics (46%) and MOPI (5%). The debt consists of a bank loan in year 2 and 3
and a loan of the equipment vendors. Exhibit 1 gives an overview of the construction plan and
exhibit 2
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Exhibit 1: Timeline for construction financing

INVESTMENTS
Equity (in millions) Split (%) Proportion in US
Dollars ($)
Rmb Proportion in US
Dollars ($)
Interest
rate (%)
Tianjin Plastic 46 7,59 14%
Maple Energy 49 8,09 9%
MOPI 5 0,82 14%
Total Equity US dollars
($) proportion
49 8,09
Total Equity Rmb
Proportion
51 8,42
Debt (in millions):
Bank loan year 2 36 27,50 9%
Bank loan year 3 36 27,50 9%
Equipment vendors
(10%)
Equipment vendors
(90%)
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19,80
2,20 14%
Total Debt US proportion 97 74,80
Total Debt Rmb
proportion
3 2,20
Total investment 93.5
Exhibit 2: Investments
3.2 Post-Completion Financing
This is the phase when the cash flow start to be collected and also the service debt payments are made.
There is a total Enterprise Value of $117.4 million. The loan ($16.5 million) can be transferred to current
equity, after the power plant construction and testing. The total debt is $100.9 million, this can be divided
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into a principal ($77 million) and accrued interest ($23.9 million). We calculated the WACC of this
project and is at 9.3%, as shown in the exhibit below.
CAPITAL STRUCTURE
(2000)

US $ (millions) Proportion (%) Cost Of Capital (%)
Equity: 18,0%
Tianjin Plastic 7,59
Maple Energy 8,085
MOPI 0,825
Total Equity 16,5 14,1%
Debt: 7,8%
Accrued Interest 23,9
Principle debt 77
Total Debt 100,9 85,9%
Total Enterprise Value 117,4
WACC 9,3%
Exhibit 3: Capital structure
3.3 Using Flow-to-equity method
For measuring the business and operational performance of the company of this project, there are several
important ratios such as D/E, Debt Service Coverage Ratio, the payback time ratio, IRR and NPV. In this
method is used the free cash flow to calculate some of the above indicators. This method is a way to
measure the amount of cash that can be paid to equity shareholders of Maple after all expenses,
reinvestments and debt repayment. The free cash flows are calculated after taking into account all
payments to and from debt holders. Then we discounted the cash flows by using equity cost of capital
(18%). The free cash flow to equity is discounted to year 2000 (T=0), this makes it possible to calculate
the payback time, IRR and NPV (which we consider as the most important for the evaluation of the
financing decision). With these calculations we can compare the different financing choices: indexed to
the dollar, back-to-back loan and swaps. Using the Interest Parity Theory, we assumed a 5% appreciation
of the USD to RMB, since interest rate is 5% lower in the US compared to Rmb.
3.4 Risks Associated With Return
The contract settled between the Maple Company and Chinese authorities indicated the primary condition
upon which the project would work. There were stated the specific amount of power and the future cash
flows. The return receivable for the 20 years of economic life was calculated at Rmb 78,000,000. Also
there is a huge market and business opportunity to 21 Gigawatts of new capacity each year, for the
coming decade. Also the reduction of the most important variable cost as coal, by the government
throughout the whole duration of the project, was another advantage. But, despite these profits, there was
a possibility that the Chinese government was going to limit the level of ROI at 15-17% and also was the
registered equity would not be allowed to repatriate.
Due to considered risks mentioned above, one of the main indicators for comparing the different types of
financing is the payback ratio and IRR. The currency risk is of a very significant importance due to the
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fact that it impacts on the remittances to its parent company in US. Most of the risks that Maple faces are
related to the characteristics of an emerging market such as that of China. To prevent this, it is important
for the company to choose a financing choice with a low payback time, and to repatriate the income at the
appropriate time to avoid as much as possible the effects of the appreciation of the currency. Comparing
the different financing choices, will give us an overview of the best option to mitigate the risk related to
the currency convertibility. Although we assume that the parameter payback time is the most important
indicator for deciding which financing choice to implement.
Cost of debt Cost of equity WACC IRR NPV Payback
time
Dollar indexed
rate
7,83% 18,00% 9,26% 25,09% $1,58 6,03
Back-to-back 7,83% 10,5% 8,30% 48,14% $14,82 4,91
RMB swap 13% 14% 13,14% 32,19% $5,78 5,02
Exhibit 4: Financing choices
We decided to choose the financing choice with the lowest payback time to minimize the risk.
As shown in exhibit 4 the back-to-back loan with Wintel has the lowest payback time (4,91). The
risk is lower, because Maple can earn its invested capital faster. Looking to the two other
parameters, IRR and NPV, this choice also seems to be the best financing choice. A risk Maple
faces with this choice, is that Maple is dependent on Wintel.
The expected return is calculated by the following formula: ROE = net income / shareholders
capital. The average net income is $17.31 million and the shareholders capital is $16.5 million.
Using the formula, it gives us a ROE of 5%.
But as it was stated in the end of the case, even the possibility of back-to-back loan couldnt lock
in completely the risk of the currency exchange. So we saw it reasonable to seek for
opportunities to solve the situation in the long run, due to the great potential that the power
market in China offers (120 gigawatts for the next decade) which would benefit both government
and Maple. The possibility for an agreement with the multilateral agencies such as World Bank
or International Finance Corporation to step in and assist the government in establishing a
domestic capital market, by setting a group of regulatory frameworks, thus contributing in a
trustworthy financial system and a liquidity source for companies and a flexible environment of
currency hedging opportunities.



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4. Conclusion
In the above analysis we considered the several risks related to the Maple Company, in which we realized
that the weight of the political risk and currency risk would play a much higher role in the companys
decision in the future. Relating these two main elements of the viability of the investment, and after
calculating the key ratios (IRR, NPV, payback ratio) we came up with the conclusion that the best
solution from those suggested in the case was the back-to-back loan between the Maple and Wintel
company, which in the other hand wouldnt completely mitigate the currency risk, but also would raise
the dependency of the Maple on Wintel.
So we would suggest a possible opportunity underlying the international agreements with
multilateral agencies (such as World Bank, International Finance Corporation etc.) which are
very willing to help such projects in developing countries. The best arrangement would be to
seek the establishing of an efficient capital market for hedging the currency risks and at the same
time offering liquidity opportunities to investing companies in China.
5. Similarities & Differences with DBFMO projects
Both as project finance cases have a set of similarities:
- An existence of an SPV which contains only the specific business of the Project and is a
separated entity (DBFMO-Maple),
- The financing structure is characterized by a considerably high leverage compared to other
businesses.
- The financing is provided usually in non-recourse agreements with no or limited guarantied
collateral to lenders, next to cash flows.
The differences that we can find relate to specific environments where the DBFMO operates and the
specific risks it faces, related to it.
- First DBFMO is diversified in more countries and continents, thus creating the possibility of
hedging several risks, while Maple has had the operations only in South America, United
Kingdom and finally India and China.
- Secondly by its size we can conclude the larger opportunities of the company towards capital
markets and opportunities of diversifying the capital (as a clue indicator for success in project
finance, as stated above). Also the level of risks borne by the DBFMO was usually lower (near
8%) and for the Maple this was nearly 15% (with prospects to be higher).